How to Get More When the Stock Market Goes Up But Not Lose Anything When the Stock Market Goes Down

What if I said that you can earn more interest when the stock market goes up, but have no principal or interest taken away when the stock market goes down?  Would that interest you?  Several insurance and annuity companies give you that opportunity.

So many were burned in the stock market crash of 2008; people took their money out and put it in safer investments.  Many found their way into “fixed index” based interest bearing accounts in annuities and life insurance accounts.  What the heck does that mean?  These have become increasingly popular for good reason.  Understanding it is easier even though there are several moving parts.

This is the first in a series of posts explaining how this works and how it applies to different kinds of contracts.  Fixed Index based interest can be a key piece in setting up our dominoes to get our affairs in order with Safe placement of funds to create Life Long Income.

Let’s break it down.

• “Fixed” refers to the fact there is a contractual agreement about calculating the interest that adds to your account.  The number is not “fixed”; such as a 2% rate.  However, the formula which calculates interest is what the contract term makes “fixed”.

• “Index” means the contractually fixed calculation includes some percentage of an increase in a stock market index (such as the S&P 500).  Your money is not in the stock market and it is not invested in the selected index.  However, when your interest earnings calculate, how much that index goes up can increase how much interest you get.  The formula stays fixed while any growth in the index triggers more interest in addition to any minimums promised.

The good news includes this.  When the selected index goes down, the calculation of your interest never goes below zero.  They do not take away any of your principal.  Also, they do not take away any of the interest already added to your account from previous calculations.  You benefit from the added interest when the selected stock market index goes up; but, you lose nothing when that selected stock market index goes down.

Is this the best of both worlds?  If you want safety it can be.  Remember, we are talking about interest additions to your account.  This is not a guaranteed direct investment in the stock market.  That means, if the stock market shoots way up you will not earn as much as if you took the risk of a direct investment.  This is the tradeoff for not losing anything when the market drops.

There is an interesting affect to this.  You earn interest as the market index rises.  When the index goes down, you can start earning interest again when it starts climbing up to its former level.  The reason is your interest adds to the account again when an increase happens, even if those are increases climbing back up from a loss.  So, something strange occurs. There is even a benefit in these accounts over time when there were periodic drops in the index value.

Choices of Indices.  While most people include the S&P 500 as their index of choice, companies have different choices you can make.  Blended choices exist such as the S&P 500 with the Dow-Jones and other combinations.  You usually get to make these selections each year.  So, you can, to a degree, manage the potential growth of the amount of interest you can get.  If you think in the coming year one available index will do better than your current selection, change it.  Some contracts let you make a choice to take advantage of the best results that happen from a set of indices.  Then, you can sit back and watch that happen for you without dealing with ongoing choices.

How much extra interest do you get when the selected index goes up?  Since this is an addition of interest, not an increase in the underlying values of the index, you do not get the whole amount of growth of the index.  For example, if the S&P 500 goes up 10%, you do not receive added interest amounting to 10% of your account.  The company gives you a portion of that and keeps some for themselves to make their profit.  There are two key ways how much you get is decided; Participation Rates and Caps.

• “Participation Rate” is the level of your participation in the growth of the index.  The companies periodically agree to a participation rate under the terms of your contract.  That rate of participation may be 50% of the growth of the index in a year.  Going back to our example, that means if the S&P 500 went up 10%, you would share in 5 points (50% of 10%).  Most contracts nowadays have at least a 100% participation rate.  New rules require illustrations that try to project how much you can earn when buying one of these contracts to show at least a 100% participation rate.  There are some companies that credit you with more.

• “Caps” are a limit you agree to up-front on how much your participation can earn in any year.  For example, let’s say the growth of the index in a specific year is 20%.  Your participation rate may be 100%.  However, the terms of the contract say that in no year will your account grow by more than 12%.  So, in that year of 20% growth of the index, you get extra interest equal only to 12% of your account balance.  What if the growth of the index were only 9%? Since the participation rate is 100% and the cap is 12%; then your addition of interest would be the full 9% of the growth of the index.  Keep in mind these are all steps of a calculation described in your contract.  That makes this a “fixed” interest rate because the formula is set.

In any event, each year the calculations are done and the resulting interest is added to your account.  You know what is happening.  The annuity and life insurance companies are regulated and audited.  That gives comfort you will receive what you are entitled to.

Is this better than stock market investing?  If you are ready to make safety your priority it is.  The simple reason is you cannot lose any principal or what you have already earned if your selected index goes down in value.  During years you are willing and able to take risk and you want to increase your portfolio value the most that is possible, then, stock market investing might be right for you.  But most people planning for retirement are more interested in keeping what they have first.

My view is this.  The historical rate of return of the stock market over time is 9%. Of course, people who “play” the market can earn a great deal more in any one year.  But that takes time, attention, and knowledge.  How many of us are capable of putting in that time, attention, and gaining the necessary knowledge?  So, to get safety for direct investments in the stock market we need to have designed for us a safe, diversified, “portfolio” managed by people who do or invest in mutual funds.  Their fees and commissions reduce how much we can earn.  At the same time, there are studies that show fixed index interest over time can compete nicely with “portfolio management”.  Even if we earn somewhat less, we have the comfort we cannot suffer a market loss.  We will not lose our money.

Is this a better way to go than other “safe” investments?  You can earn more interest when your selected index goes up.  In these times of low interest rates, this is a safe way to earn more interest than something with a stated rate.  Certificates of Deposit have FDIC insurance, but their historically low rates of interest make them less attractive than fixed index interest contracts.  The fear is your CD interest will not even keep up with inflation; so, you lose real money by the loss of purchasing power. The annuity and life insurance companies that make these contracts are regulated, audited, and must keep separate reserves to meet their obligations to you.  The guarantees from these companies, while not backed by the full faith and credit of the United States, make the safety very good.  Your money will be there when you are ready to start taking distributions, usually at retirement.

Should you put your money in fixed index interest contracts?

• These are best for people that have “piled up” a nest egg they want to preserve.  Safety is their key concern.  They believe preserving their capital is more important than the income they earn on it.  With fixed index interest bearing contracts, you can guarantee preserving your capital and still get reasonable growth for the future.
• Also, these are best for people who are looking for mid to long-term growth.  The accounts are not designed to dramatically jump up in any year.  But, you will never see your account balance go below what it was the year before.
• Plus, this is not for that portion of your portfolio you need to dip into for current expenses.  The interest earned is added to the balance to help future growth.  Fixed index interest contracts are not suitable to get you current income. Some contracts provide for some limited access or for the expenses of terminal illness or long term care needs.

You want fixed index interest bearing contracts in the following circumstances.

• You will set them up.
• Then you let them grow on a tax-advantaged basis.
• When you are ready to retire, they can then give you tax-advantaged retirement income that can last for the rest of your life.

In the next installments I will describe how the annuity and life insurance contracts that provide fixed index interest work.  Like anything else, there are pros and cons, depending on what you are trying to carry out.  We will review those so you can best decide what suits you.

For answers to your question or information on how this applies to you get in touch with me at scottfbarnett@scottfbarnettconsulting.com.